Intro to Accounting for Foreign Currency and Inflation: The Value of Money in a

1
Intro to Accounting for Foreign Currency and
InflationThe Value of Money in a Floating
Rate World

• Overview History
• Floating vs Fixed Rates
• Economic Effects of a Floating Rate System

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A Few Basics about The Concept of Money

• One of the main functions of the idea of money
  is to make exchange (trade) more efficient.
• A major innovation is in allowing timing
  differences between production and consumption
• The idea of money is itself not tangible. Thus
  it is spiritual, but not necessarily physical in
  nature.
• The worth of money can be measured based on
  what it can be exchanged for.

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A few Basics about the Concept of Paper Money

• Anything can serve as money.
• Traditionally, and perhaps because they were
  rare, portable, and with fixed and limited
  supply, gold and other rare minerals often served
  as money.
• In recent times (since 1700s), paper has
  traditionally been used as money, along with, or
  as a substitute for, physical gold.

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The Problem with Paper

• Paper is readily, and cheaply, obtainable. Thus,
  in and of itself, it has little inherent worth.

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The Solution to the Problem

• To make paper rare and believable as a thing of
  stored value, it was specially imprinted and
  designed, issued as a draft, or note, by a bank,
  and/or made convertible into physical gold or
  other precious metals.
• The advantage of paper over gold is that the
  supply can be increased on demand, as needed.
• This can be helpful when economies and markets
  are expanding quickly- paper can easily be
  supplied to meet demand for additional cash to
  facilitate trade and other financial activity.

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The Concept of Foreign Exchange

• Modern economies usually have a central bank that
  issues the paper money of that nation (or in the
  case of the EU, that confederacy of nations).
• The central bank, ideally, issues enough paper to
  meet the demands of trade, but not so much that
  the currency is cheapened (too much money chasing
  too few goods)
• Foreign exchange involves the exchange of one
  currency for another.
• Direct and indirect rates of exchange are quoted
  for this purpose.

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International Foreign Exchange- History1800s and
early 1900s

• In 1800s, pound sterling was the reserve currency
  of the world.
• Most currencies were linked to sterling and/or
  gold.

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International Foreign Exchange- HistoryThe
Depression Years (1930-1940)

• Depression years saw many currency devaluations
  as countries tried to compete in weak global
  markets.
• Rather than face severe economic decline, UK
  abandoned the gold standard. As a result,
  Sterling lost its seat as the worlds reserve
  currency.
• Many countries, starved for gold reserves, and
  facing severe deflation, sought to abandon the
  gold standard.

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International Foreign Exchange- HistoryThe
Depression Years (1930-1940)

• In the US, in 1933, American citizens were
  required to sell their gold at a price of 28
  per ounce. Thereafter, American citizens were not
  allowed to own gold, except in the form of
  jewelry.
• The confiscated gold was then used to back the
  issuance of much more currency (convertible at
  35/oz) - this to fund the new deal, in the
  hope of reviving the economy, and mitigating
  deflation.
• It didnt work- the country stayed in depression
  for ten painful years.
• The depression finally ended with the advent of
  WWII.

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International Foreign Exchange- History1944-1967

• During WWII, the USA produced arms and sold them
  to the Allies in exchange for physical gold and
  promissory notes.
• By the end of WWII, much of the gold in the world
  was now stored in American vaults.
• This imbalance created a need for some other
  monetary basis. As a result, the Bretton Woods
  agreement emerged.
• The US was tied to gold. Other currencies were
  linked, at a fixed rate of exchange, to the
  dollar. The dollar thus became the new reserve
  currency of the world.
• For more than 20 years, this system worked well
  and responsively, in the face of rapid expansion
  of the world economy, amazing new innovations,
  and rising standards of living in many
  industrialized countries.

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International Foreign Exchange- HistoryThe
Inflation Years 1967-1980

• In the mid 1960s, trouble began as world
  economies became overextended and equity markets
  peaked.
• In the mid 1960s, The USA became involved in
  Vietnam. By 1967, the war was in full swing. Much
  more paper was needed to finance the war than
  gold reserves would allow.
• At first, the US printed paper anyway.
• When markets became aware of the increased
  amounts of currency, countries began to come to
  the gold window to exchange US for gold.
• Massive amounts of gold began to leave the
  country.

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International Foreign Exchange- HistoryThe
Inflation Years (1967-1980)

• In 1974, to stop the gold drain, President Nixon
  abandoned the gold standard and closed the gold
  window. The Bretton Woods agreement collapsed.
• In its place a Floating Rate system was
  installed.

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International Foreign Exchange- HistoryThe
Concept of a Floating Rate

• From 1974 on, the US , and thus most other
  currencies, were no longer backed by gold. Paper
  money, although formally a form of credit, is now
  really backed by nothing except faith, i.e.,
  the collective conscience of society concerning
  its worth.
• Advantages
• No reserve of gold is needed to back currency.
• Greater freedom to create money and stimulate
  demand.
• Disparate inflation rates cant, as easily,
  disrupt capital flows and trade.

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International Foreign Exchange- HistoryThe
Concept of Floating Rate

• Disadvantages of a floating rate system-
• No restraint on governments propensity to
  devalue currency- usually to finance govt
  spending or to avoid politically unpalatable
  economic pain.
• Can induce greater asset price volatility,
  especially when coupled with a fractional
  reserve money-creating mechanism (i.e., the
  creation of credit).
• Foreign exchange rate volatility and risk are now
  directly borne by market agents, i.e., companies,
  investors, etc.

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How Money is created in a floating rate,
fractional reserve system

• The central bank buys something, usually
  government debt, from banks, arbitrarily creating
  currency for use in the swap.
• The bank adds the currency to its reserves and
  lends the money out.
• Since reserves of 10 or less are typically
  needed to support a given level of lending, the
  amount lent is significantly more than what was
  originally created by the central bank.
• Other banks, upon receiving newly borrowed funds
  as deposits, also lend more.
• The result? 1 US dollar initially created by the
  central bank can end up adding 10-15 times as
  much to the money supply.
• The flood of new funds lowers interest rates,
  stimulating new investment, consumption, and
  lending, which in turn drives up prices.
• As prices rise, and the value of money falls,
  lenders respond by increasing interest rates in
  order to earn a fair rate of return on their
  loans.

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International Foreign Exchange- History1980-Today

• As with all prior fiat money, credit-based
  systems ever tried, the nation, and world, thus
  began to experience certain phenomena
• Booms and busts. Credit (and economic activity)
  in the system sharply expanding, followed by
  marked contractions as investors, fearing credit
  was over-extended, called loans and sought safety
  and liquidity.
• Imbalances in trade relationships began to occur.
• Assets of various types (housing, stocks, bonds,
  oil, gold, etc.) began to cycle through periods
  of boom and bust.
• On average, however, prices rose (inflation),
  reflecting a long term trend of the devaluation
  of paper money.
• High levels of debt and reduced savings became
  commonplace.
• Major shifts occurred in the value of one
  currency versus another as nations attempted to
  manipulate the rate of exchange, trade, and/or
  the business cycle.
• Hyperinflation was experienced in many developing
  nations.

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Traditionally

• Fiat currency, including paper, while
  theoretically a valid form of money, has always
  become worthless over time (example China,
  Rome).
• The ancient Chinese Empire, for example, was
  forced to abandon fiat currency because they
  found it was inflationary. In other words, such
  money could not hold its value.
• Similar devaluations have been experienced in
  numerous other civilizations, including Rome, the
  UK, and many others.
• The US is no exception! The US has lost 98 of
  its value over the last 100 years!

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Why Fiat Paper Money is something all politicians
secretly love

• When money is devalued, it amounts to a kind of
  tax.
• People respond to that tax by making adjustments
  to lessen it. These include buying real goods,
  even if not needed, over-borrowing, and
  over-investing.
• Thus, and strangely, the tax occurs in a way that
  can actually stimulate the economy and increase
  trade.
• Unfortunately, as we all inherently know, there
  is a cost to all forms of tax. Its only a
  question of when it will be paid, and by whom

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The Question of Who Pays and Who Benefits

• In a floating rate system, if you are fortunate
  enough to be the worlds reserve paper currency
  provider, you can
• Exchange paper, with no inherent value, for real
  goods and services.
• Control economic activity and capital flows.
• To the extent others cooperate, you can export
  some of your inflation to other countries. In
  effect, then, the tax is itself exported.
• The exporting of such reserves cause the boom and
  bust cycle to manifest elsewhere.
• This actually stimulates world trade, making it
  attractive for all concerned.

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Causes of Exchange Rate Movements

• Only well understood reason Inflation
• Other possibilities
• Trade imbalances
• Demand and supply of investment cash flows
• Fiscal deficits
• Economic growth
• Interest rates
• Political turmoil and stability
• and so on.

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Euro Versus US Dollar
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Japanese Yen Versus US Dollar
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British Pound Versus US Dollar
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Mexican Peso Versus US Dollar
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The Problem of Making Sound Economic Judgements
in a World of Floating Rates

• Its hard to determine the real value of goods
  and services produced and given.
• One way is to value things in terms of something
  traditionally monetary and real, e.g., gold.
• Example
• You buy a house for 200,000.
• It appreciates to 380,000 over 5 years, or 90
• /oz of Gold increases from 265 to 590 (125)
• House in gold oz Before 755 oz, After644 oz
• Conclusion House depreciated 15 in terms of
  gold.

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Gold Versus US Dollar
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Light Crude Oil Versus US Dollar
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The Problem With Floating Rates

• Another example
• You get a 25 raise over 5 years.
• Gold appreciates 125
• Gasoline increases from 1.25 to 2.50 (100).
• Houses and many other real goods and services
  increase 100 or more in the same 5 years.
• Conclusion You may have actually taken a
  significant pay cut while feeling your income,
  and wealth, was increasing!

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Why do governments devalue currencies?

• Disincentive for saving.
• To prevent economic decline. Borrowing and
  spending are encouraged.
• Creditors are better protected (assets securing
  loans grow in nominal terms).
• Goods and services are more competitively priced
  to overseas buyers.
• Discourages buying of imports

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In fact

• Currency devaluation (manipulation) is a classic
  response to worldwide economic decline
  (instability).
• The reason Its politically more palatable for
  everyone to take a pay cut, and prices
  (nominally) to rise, than for some (in 1933, 25)
  to lose their jobs and for prices to decline
  sharply, forcing large-scale bankruptcies and
  defaults.
• To accomplish this, there has to be great
  quantities of something (government debt) around
  for the central bank to buy. In 1933, this
  trick was not possible because there was little
  government debt and the worlds currencies were
  tied to gold.

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An example of the measurement problems inherent
in a floating rate system

• Has the national debt really grown? What if
• Total government debt has grown nominally by
  about 1/3 (6 trillion in 2002 to 8 trillion (?)
  in 2006) in 4 years?
• The value of the dollar, in terms of gold has
  decreased by more than 50 over the same time
  frame.
• In terms of gold, the national debt has thus
  shrunk considerably.

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The Problem with Currency Devaluation
(revaluation) from an Accounting Standpoint

• One of the assumptions behind all financial
  reports is that the monetary unit is the same.
• If currency changes value over time, the monetary
  units () represented on financial statements are
  not the same.
• As such, they cannot be added or interpreted
  meaningfully.